In the face of uncertainties in global and domestic financial markets, short-term income funds as a category seems a good choice for now. High short-term rates should provide good regular accruals, and the relatively low duration of these funds should provide capital gains in case of a decrease in interest rates. If interest rates continue to move up, returns would suffer somewhat but a relatively lower duration should come handy in limiting the damage. This category has done relatively well in recent months. Investors though should always analyse the risk-return trade-off clearly before investing.

The current tightening cycle of the RBI is now into the 20th month. RBI has hiked its key rates by a staggering 12 times, leading to a cumulative increase of 500 bps in the repo rate from March 2010. WPI inflation, which was in negative territory in July ?09, spiked up sharply to hit the double-digit mark at 10.36% in March?10. The main contributor to such high inflation was food article prices. Manufacturing inflation, the barometer for strong demand in system and pricing power of manufacturers, is also close to 8%. During the same period, short-term rates represented by 3-month commercial paper (CP) rates have also moved up from 4.00% then to about 10% currently.

In the long-end, the benchmark 10-year government bond yields, which held firm in 8.25-8.35% levels till until last month, have spiked sharply to around 8.80% this month, after the government announced an increase in the borrowing programme. Alongside, the liquidity in the system has remained largely negative over the last 18 months.

Economists apprehend that higher interest costs and tight liquidity may affect India?s GDP growth in the near term.

Even though India?s economic fundamentals remain extremely strong. Industry bodies and sections of government are already asking for a pause in the tightening cycle to induce a revival in economic activity. RBI in the last few policies has clearly spelt out its objective of preserving the long-term growth potential at the cost of a short-term slow down. One can feel confident that RBI will, as in the past, definitely succeed in bringing down inflation over a period without sacrificing much growth.

Economists expect a moderation in inflation in coming months mainly on a strong base effect and lower commodity prices in global markets. A 10% depreciation in INR vs USD since has partly neutralised the impact of lower commodity prices. A good monsoon has still not resulted in lower food prices. The current European crisis seems to be close to some interim climax, raising the hope of a mild revival in global economy. As such, one has to really wait and hope for inflation to slow down over the next two quarters. However, it is reasonably clear that we are in a fairly advanced stage of the current tightening cycle.

It is, therefore, possible to draw some conclusion on the likely range of short-term interest rates over the next year. In 2010, following large unexpected loan demand from telecom companies, strong demand from the infrastructure sector and large cash balances of the government, liquidity tightened and short-term rates spiked up. The credit?deposit ratio of the banking system was above one for a better part of the year, meaning banks were lending more than they get as deposits. Following a record subscription in Coal India?s IPO, system liquidity came under severe strain, necessitating special liquidity infusion measures from RBI. As a result, banks hiked deposit rates aggressively in order to attract fresh deposits. By this time inflation was consistently going up and market rates started pricing in expectations of stronger rate hikes by RBI. Consequently, short- term rates moved up very fast and spreads between repo rate and short-term market rates widened

to a near historical high of 400 bps+ in March?11.

Liquidity situation thereafter improved with government spending and fresh system flows. Liquidity has since remained balanced and short-term rates corrected downwards. With the recent trend of a slowdown in incremental credit demand, short-term rates (up to one year) have since remained range bound between its March highs and April lows. As such, it seems that short-term rates may already have peaked in the current interest cycle in March, even though RBI has continued with the rate hikes. They may now fluctuate between their March high and April lows.

As for long-term rates, the recent increase in the government borrowing programme may continue to put pressure on long term rates until a major part of the borrowing is completed. While very high oil prices may result in higher subsidies, volatility in equity markets may undermine the disinvestment targets. All these may affect fiscal deficit and inflation. Thus, better visibility has to emerge on these factors before a decisive view on long-term bond yields can be found.

With the overall interest rate environment uncertain, one would expect a small rise in 10-year yields, may be a push towards 9.00% levels, in the near term.

Several debt instruments are available for investors

Try long-term fixed maturity plans or zero coupon bonds to lock in at higher interest rates

The Nifty has corrected by around 20% YTD mainly due to the European debt crisis, fears of recession in the US and a persistently high domestic inflation. The equity markets are expected to remain volatile given that policy makers in the US and Europe are still to find a long-term solution to revive their economies and domestic inflation remains sticky despite RBI hiking rates by more than 12 times since March 2010. The poor performance and high volatility of the equity markets have lead to investors increasing their allocation towards safer investment avenues like debt. The rate hikes by RBI to tame inflation has led to an increase in the interest rates, which make investing in debt even more attractive.

Several options are available for investors looking to increase their allocation towards debt depending on their investment objective. Traditionally, investors in India tend to park their funds in fixed deposits of banks. But over the last few years, fixed maturity plans (FMPs) of mutual funds have also become extremely popular among investors as they offer attractive yields and are more tax efficient than the traditional fixed deposits. These instruments allow the investor to lock in an attractive yield for a given time horizon. For example, if a two-year FMP yields the investor a 10% compounded annual return, the payout stands at 121 at maturity for every Rs 100 invested irrespective of the level of interest rates at maturity or within the passage of two years. This is not the case with a coupon bearing bond.

A two-year bond currently priced at par paying a quarterly coupon of 10% will yield 10% at maturity only if all the coupons paid are re-invested at rate of 10% for the residual tenure. The bond will yield less than 10% if the coupon are re invested at rate lower than 10% and will yield higher 10% if the coupons are re invested at a rate higher than 10%. This is an important distinction which makes FMPs/FDs safer debt instruments as they do not bear any reinvestment risk.

In a rising interest rate environment they are ideal investment avenues for risk-averse investors with no requirement for interim cash flows. FMPs score higher in terms of post-tax returns as the investor can treat returns as capital gains and also claim indexation for longer tenures. Post-Direct Taxes Code, the holding period would be revised upwards (from currently one year) for one to claim indexation.

Another alternative to lock in high interest rates without any reinvestment risk are zero coupon bonds like Bhavishya Nirman Bond of Nabard. These not only enable investors to lock in an attractive yield for longer period (residual maturity is seven to eight years) and are also extremely tax efficient.

On the other hand, investors looking for regular and steady cash flows should invest in coupon bearing bonds. A number of companies have hit the market with public issues in the recent past and raised money. In these cases, it is very important that the investment horizon and tenure of the bond should be identical in order to avoid mark to market fluctuations.

The above alternatives are examples of instruments which are good for investors wanting to hold their investments till maturity. There are many investors who also want to play on interest rate cycles. This, basically, is a play on making capital gains on your bond/fund investments when interest rates come down. Income and gilt funds are ideally suited to capture this strategy of fixed income investing. These funds invest in long dated corporate bonds and long dated government securities respectively, prices of which are very sensitive to changes in interest rates. Investors can make potential gains if interest rates start coming down after they have invested but can make losses if the reverse happens. The experience in such strategies has not been good for investors as most of the times they get caught on the wrong end of the cycle. In my experience, it is always advisable to keep a large proportion of your investments in \’hold to maturity investments\’ (Like FMPs) and a very low proportion of your investments towards investments wanting to play on interest rate cycles.

So where does equity fit in the given environment? The answer to this question is simple, it all depends upon the investors current asset allocation and risk appetite. The asset allocation decision is the driver of long-term wealth creation. Strategic asset allocation is a practice of creating a portfolio which is determined by the investors risk tolerance and return objective and not by short-term market trends. Tactical asset allocation is a practice of making minor adjustments to the strategic allocation depending upon the prevailing market condition.

Tactical allocation can be defined by the price-to-equity (P/E) levels of the market where an investor buys more when markets are cheaper (lower P/E) and stays away from the market when the P/Es are high.